-16.08(-0.22%)

+1.84(+0.12%)

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-6.30(-0.47%)

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How to Pick Cinderella Stocks

Did you follow the NCAA tournament this year? Maybe you even participated in one of the fantasy tournaments online where you pick teams in each bracket.

Every year the tournament has its upsets with a #14 seed beating a #3 seed, and this year was no different. The problem with filling out the bracket is: How do you know who is going to be the Cinderella team?

This year, Florida Gulf Coast became only the seventh #15 seed to beat a #2 seed in tournament history. It was also the first #15 seed to make it to the Sweet Sixteen.

Be honest. You didn't pick Florida Gulf Coast to win its first game in your bracket, did you? There's always one team that no one really foresaw getting it together just in time for the Big Dance. Trying to guess who it will be is part of the fun of watching.

Stock picking can be a lot like filling out the NCAA bracket. There are plenty of #1 seeds and everyone knows who they are. Those big guns are companies like Apple and Caterpillar. If you invest in one of them, odds are on your side.

This year, Wichita State, a #9 seed, stunned the tournament by being the first #9 seed to make it to the Final Four. But how do you find the Cinderella stocks that are the #9 seed but play like the #1s? These are stocks that are flying under the radar. They may be turning around their business but investors aren't paying attention yet.

These stocks, like the #9 seeds, may look similar on paper but some will have the special magic to break out of the pack.

Suddenly, this stock jumped from a Zacks Rank #3 (Hold) to a Zacks Rank #1 Strong Buy. But even more remarkable is that its rank is rising ahead of the earnings report. Now analysts are bullish about the company and raising estimates before it reports earnings.

Today you can be among the first to get in while the stock is still cheap - a great value - before other investors clamber aboard.

To be a Cinderella story in the NCAA tournament you have to win. (Obviously!)

For companies, though, the winning begins when its earnings history starts to turn around. Many times, the analysts are slow to recognize that there is a change in the trajectory of the company, so the company starts easily surprising on the estimate every quarter.

Winning, then, is a company putting up big earnings surprises or a streak of them. When this happens, the analysts will usually start raising their own estimates in expectation of better things still to come. This good news leads to rising estimates and, hopefully, earnings growth.

Choose stocks that have rising estimates.

#2: Buy Growth Stocks

Companies that are turning it around can be found in any sector. They can be big or small. But the best returns come from buying the stocks that have the highest growth rates. That is because once the turnaround takes place, the PE will start to rise from abnormally low levels. The higher the growth rate of the company, the more the multiple will expand and the greater your final return.

Focus on growth stocks for the best turnaround profits.

#3: Value Is Still King

Not every cheap stock is a bargain. Fundamentals, such as rising earnings, still matter. A company may trade for a $1 but if it's just days away from bankruptcy then it's likely not going to be a good turnaround possibility.

In the NCAA, the bracket busters almost always come from a Cinderella team. It's not risky to pick all four #1 seeds to make it to the finals. But betting on a #9 seed to make it there? That takes a lot of guts.

It also takes guts to buy a turnaround stock. You can cut down on the risk by buying one that is trading at a discount to its peers. I use low PE, PEG and Price-to-Book ratios as a way to find value.

Where to Find Cinderella Stocks Right Now

Turnarounds can easily be detected when a company's earnings estimates suddenly reverse from downward to upward. So the proof of the turnaround occurs when a stock makes a sudden leapfrog from a lowly Zacks Rank #5 (Strong Sell), Zacks Rank #4 (Sell) or Zacks Rank #3 (Hold) all the way to a Zacks Rank #1 (Strong Buy).

In fact, I'm directing a turnaround detection strategy that combines these Zacks Rank movements with valuation and aggressive growth factors. During 2013 alone, it has already closed four double-digit gains and is now riding four others.*

If you'd like to look into Zacks' Turnaround Trader, I suggest you do it right now. The number of investors who share its recommendations must be limited, and a lot of new people are sure to climb aboard.